Svetlana Borovkova: Are corporate bonds sensitive to ESG and news sentiment?
By Dr. Svetlana Borovkova, Head of Quant Modelling at Probability & Partners
In my Financial Investigator columns of May and June 2020 and February 2021, I have written about the role of news sentiment in stock and index investing. We have seen how monitoring sentiment in news and social media can help reduce risk and generate alpha, be it as a stand-alone signal or as an overlay of existing investment strategies. The role of ESG scores in stock investing has also featured in my columns of July 2020 and March 2021.
But, of course, a well-diversified portfolio does not consist of equity only. Fixed income instruments such as government and corporate bonds often make up a large part of an investment portfolio. What about sentiment signals for that part of your portfolio? And what can we say about the interplay between corporate bond performance versus ESG scores? These are the topics of two Probability & Partners papers, recently published on our website, in which we focus on bonds rather than stocks.
Bond yields versus news sentiment
First of all, there are difficulties in dealing with bonds rather than stocks. A company typically has just one type of common stock, but issues many bonds of different maturities and with different features. So how can we summarize the performance of all these bonds for a particular company?
For that, we can calculate the ‘average’ bond yield spread over the relevant risk-free rate, which will take into account every bond’s maturity and coupon characteristics, but will still reflect the ‘typical’ spread that companies must pay to borrow money from the market. It is these ‘average’ bond yields for all S&P 500 bond index companies that we studied and related to company-specific media sentiment and ESG scores.
It turns out that, as sentiment about a company declines, the yield spread on the company’s bonds increases. This is logical, as it reflects the fact that a company perceived to be in trouble (and hence, more risky) must pay more to borrow money. The opposite is also true – an increase in sentiment leads to a lower yield spread – but this effect is less pronounced.
Hence, as with equities, negative sentiment seems to have a greater effect on corporate bonds than positive sentiment, and so, can serve as an excellent risk indicator. The role of sentiment is greatest for high-yield bonds, while investment grade bonds are less sensitive to sentiment fluctuations.
On the basis of these observations, we tested simple bond investing strategies, such as a long-only portfolio of top 25% of corporate bonds whose media sentiment is improving. It turns out that such a portfolio, even if rebalanced only once per month – rendering any transaction costs insignificant – significantly outperforms the bond index benchmark. On the other hand, avoiding those bonds with declining sentiment (for instance, bottom 25% of bonds in terms of sentiment) also improves bond portfolio performance.
ESG and corporate bonds
Just as we can measure ESG scores of a stock portfolio by aggregating the scores of the companies in the portfolio, we can measure an ESG score of a corporate bond by the ESG score of the company that issued the bond. And we can aggregate these scores to obtain the ESG scores of the entire corporate bond portfolio. The next question here is what the difference in bond performance is between high and low ESG-rated companies.
One may argue that lower ESG-rated companies are perceived as having a higher long-term risk and hence must pay more to raise capital. The data confirm this: we observe a negative relationship between ESG scores and bond yields. For instance, the bond yields are lower for highly ESG-rated companies than for low rated ones. This negative relationship is the strongest for the S (Social) pillar, reflecting its growing importance, as I argued in my Financial Investigator column of March 2021.
We observe that ESG rankings are evenly distributed between sectors and between high yield and investment grade bonds, meaning that bond investors have the freedom to build diversified portfolios even when paying attention to ESG constraints.
Although highly rated ESG companies generally yield less on their bonds, the difference is not large: a bond portfolio that contains only bonds of highly ESG rated companies yields 10 to 50 bp less than a portfolio of bonds with worse ESG scores. So if you impose even a rather stringent sustainability criterion on your bond portfolio, the yield sacrifice will be quite small.
For more details on this bond-related research, read our P&P white papers:
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